Investment property: When to file bankruptcy in a short sale or foreclosure

Timing is everything. Bankruptcy can be used to discharge the tax issues arising from a foreclosure or short sale, but the window of opportunity slams shut once the lender issues a 1099.

In August 2009, I closed a short sale for a client. Like most short sales, it took forever (about 9 months), but unlike most attempted short sales, this actually closed.

My client bought the townhouse as an investment, not as his residence, in 2005 with the intention of “flipping” it. Well, the real estate market plunged, and not only did he not flip the property, but he couldn’t rent it out either. He somehow stayed current on the payments, listed the property for sale as a short sale and found a buyer.

My client had to pay extra cash to the lender for a “no deficiency” short sale payoff. Even with the amount my client paid, the mortgage payoff to the lender was “short” by $60,000.00.

There are lingering problems with any short sale of investment property. The main tax problem is this: Even though the short sale payoff was a no deficiency payoff, meaning the lender could not pursue him for the $60,000.00 after closing, the lender issued a 1099C last week to the client for $60,000.00.

Lenders are required by law to issue 1099s by the first week of February in the year after any debt of $600.00 or more is forgiven or written off. There is no way to avoid the 1099. But there are ways to respond to the issuance of a 1099 after a short sale or foreclosure:

1. First, if the property was your primary residence, Form 982 can be filed with the client’s tax return. Under the Mortgage Debt Relief Act of 2007, this amount is excluded from income if the client used the property as a primary residence. In most cases, a short sale or foreclosure of a primary residence will not require a client to file bankruptcy because the income is excluded already and deficiency judgments are rare.

2. Second, if the property is not your primary residence, you can file Form 982 and claim to be “insolvent.” If you are insolvent, meaning your debts exceed assets, then the 1099 income vanishes. You have to include IRAs and retirement accounts as an asset in calculating insolvency, but IRAs and retirement accounts are exempt in bankruptcy, and the client keeps them. In my client’s case, he did claim to be insolvent, which excluded the $60,000.00 from the 1099 from his income.

3. Third, if the property was not your primary residence and you are not insolvent, the client can file a chapter 7 bankruptcy to discharge the debt. But, the bankruptcy must be filed before the 1099 is issued by the lender. Once the 1099 is issued, the forgiven debt turns into income and income cannot be discharged in a bankruptcy. So my client had a window of opportunity to clear the 1099 debt from August 2009 through January 2010 by filing bankruptcy. Filing bankruptcy at any time during that period would get rid of all personal liability for the mortgage, including the 1099 afterward.

I still believe that it is a good idea to pursue a short sale, whether you are selling a primary residence or an investment property, rather than hopping straight to a foreclosure or bankruptcy. But the tax effect of the short sale or foreclosure of any investment property has to be carefully analyzed before the window of opportunity closes and it is too late to file a bankruptcy case.